The financial crisis: From the U.S. to the world

The drama unfolding in the United States' financial markets has already attained the proportions of a major event in economic history. Its causes, and the responses by governments, central banks, and business, as well as its consequences within the U.S., in this country and around the world, will be the subject of "instant histories" appearing on bookshelves and of deeper analysis in the professional literature for years to come. Fingers will be pointed, legends will be fashioned and new policies and practices implemented.

The facile analysis is already in: Greed, the triumph of free market ideology over prudence and the reckless economic policies of the Alan Greenspan-led Federal Reserve Board and the Bush administration have created the mother of all bubbles, the bursting of which is the "perfect storm" now raging in U.S. markets with spillover effects here and around the world.

There is some merit to all three elements of the 30-second analysis heard or seen all week.

The preposterous executive compensation of the past decade or so, tied to stock market performance, coupled with golden parachutes to safeguard executives from risk, led to exactly what anyone would expect: excessive risk-taking to maximize short-term gains and thus financial rewards for those in a position to benefit from taking these risks.

Ideology also played its part. Regulators and some central bankers have long worried about the market dynamics that the explosion of new forms of assets such as financial derivatives could lead to. But with the prevailing ideology that "markets know best," concern did not lead to adequate prudential regulatory measures to better protect the institutions and better safeguard the interests of consumers, including borrowers.

U.S. economic policy played its part as well. The Bush administration, and, to some extent, its predecessor, and the Federal Reserve gave the U.S. the best economic expansion that money could buy - cheap cash, tax cuts and deficit spending. Never mind the imbalances between what the U.S. produced and what it consumed (the current account deficit) and between what its households earned and what they spent (the negative household savings rate).

But there is more to the story.

For the third decade in a row, a global expansion, synchronized with the U.S. business cycle (which has a rhythm of about 10 years, featuring recessions in 1981-82, 1991 and 2001), hit rough financial waters as the expansion matured. In October, 1987 (Black Monday), it was the stock market meltdown; in July, 1997, and into 1998, it was the Asian crisis; in 2007-08, it is the American (now the world's) crisis. In each case, monetary tightening in line with the maturing of an economic expansion had exposed weakness in the financial system.

In the financial crisis years of 1987 and 1997, the subsequent emergency injection of money by central banks led to a snap back of economic activity and a short-term burst of inflationary growth. But in those earlier periods, the U.S. "consumer of last resort" was still in shape to provide the buying power to take advantage of cheap money. This time, however, the U.S. consumer cannot help.

What happened? Since the late 1970s and throughout the 1980s, governments have been intent on making the labour market more "flexible" - another way of saying that risk was transferred from capital to labour. But workers are also consumers. As corporate profits expanded as a share of national income, households went into debt. What Henry Ford early in the last century had grasped, that paying his workers well meant he had customers for his mass-produced cars, has been largely unlearned in recent years.

And there is more. No one should underestimate the sophistication of financial markets today. The combination of very bright minds, very powerful information technology and vast amounts of data has spawned financial technology beyond the ken of ordinary mortals. So why, we might ask, has every stage of the present crisis been a surprise? The financial technology is not limited to the banks that issued mortgages, the financial institutions of all sorts that bought them and the insurers of the debt of all of the above, but is available also to the credit rating agencies, the external auditors, the supervisory office and, of course, the myriad sophisticated investors, including hedge funds, pension funds, sovereign wealth funds and so on.

This recalls the Asian crisis, during which South Korea suffered five credit-rating downgrades by one agency for a total of 12 rating points in seven months - not only a totally unprecedented sequence of events (the probability of one such downgrade is on the order of one in 1,000), but also testimony to serial failure to understand what was happening. Other Asian crisis countries had similar experiences - and all the rating agencies were involved.

And this lack of understanding of the modern-day financial world should worry us all. We do not know what we do not know. But we do know that there is no substitute for sound policy, especially U.S. policy, good behaviour and a sense of balance in markets and in our society. We also know that globalization, with its many benefits, has its costs, too.

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